3 Transfer Price - Definition a transfer price is the price at which goods (or services) are sold between divisions of a company, or between companies which have the same parent company (group) for a bank: every originated transaction (e.g. a loan or a deposit) needs to be replicated such that the assets & liabilities in the balance sheet still match: average funding rate: each asset is assumed to be replicated at one interest rate congruent replication * ) each individual asset (or liability) is assumed to be replicated * ) a.k.a. match funding Liquidity Risk Corp. Dr. Robert Fiedler Transfer Pricing p 3 / 28 LRC GmbH & Co. KG do not distribute -

4 Average Funding Rate mainly used in classical asset driven banks: typically used to replicate assets only (hardly applicable to liabilities) each asset replicated at the average funding rate (AFR) of the bank average funding rate challenges: the current AFR is a blend of historical liabilities AFR looks only backwards and averages the history AFR does not denote the term structure of assets a future change of the balance sheet changes the AFR and thus the P&L (of existing deals) AFR assumes that the current liability mix will prevail when funding new assets possibly the wrong steering impulse if e.g. a growth in assets can only be refinanced at higher market rates Liquidity Risk Corp. Dr. Robert Fiedler Transfer Pricing p 4 / 28 LRC GmbH & Co. KG do not distribute -

5 Matched Replication every originated transaction (asset or liability) is hypothetically duplicated with an individual replication transaction thought-experiment (but one which could be executed in principal) replication with external deals would inflate the balance sheet characteristics like amount and tenor of originated and replication transaction should match as close as possible cumbersome if exercised on individual basis (odd tenor, small amount, ) solution: central internal refinancing department (treasury) Liquidity Risk Corp. Dr. Robert Fiedler Transfer Pricing p 5 / 28 LRC GmbH & Co. KG do not distribute -

7 Matched Replication - Issues the originating department concludes the originated transaction T Ω with an external party at the same moment an internal transaction, the internal replication T R is contracted between the originating department and the treasury which cannot be changed in the hindsight the originating department has thereafter no further responsibilities for the external replication of T R an eventual deviation of the occurring payments from their forecasts the treasury however can execute an external replication of the internal replication T R : - immediately or deferred, fully, partly - or not the cost elements of the internal replication are constituted ex ante from forecasted (scheduled) cash flows e.g. risk neutral rate + liquidity premium, broker costs... liquidity hedging is methodologically straightforward interest rate hedging requires higher technical efforts deviations from the forecast: the costs of eventual detrimental changes (realized vs. forecasted payments) should also be included ex ante into T R Liquidity Risk Corp. Dr. Robert Fiedler Transfer Pricing p 7 / 28 LRC GmbH & Co. KG do not distribute -

12 Scheduled Interest Replication - Decomposition of Margins the originated transaction T Ω is converted into the plain vanilla floater T PV if the bank would replicate T Ω with F PV, there would be no profit: NPV(T Ω )=NPV(F PV ) consider floaters with different rates ρ but identical structure as F PV : a (hypothetical) bank with no credit risk could enter into a floater F R0 with the risk free rate ρ R0 (NPV(F R0 ) = 0) assume the bank could issue a floater at the rate ρ PV + the replication floater F R the difference to the risk free rate (the bank s funding margin) can be interpreted as the price the bank has to pay for its own credit risk the profit margin is determined as the difference between the rates of the plain vanilla floater F PV and the replication floater F R : = ρ PV ρ 0 Liquidity Risk Corp. Dr. Robert Fiedler Transfer Pricing p 12 / 28 LRC GmbH & Co. KG do not distribute -

20 CounterBalancing Capacity (CBC) - Definition CBC is a specific scenario (a strategy) with the target: simulate the bank s maximal possible cash inflow generation by using the following liquidity options the bank is long: balance sheet expansion: secured or unsecured refinancing through: new repos / borrowing from new clients drawings under assumed / contractual credit facilities taken issuing of debt balance sheet reduction: sale of assets final sale sale and buy back as the CBC is a strategy, its implementation might involve costs: the buffer needs to be refinanced; if the credit quality of the assets is higher than the bank s own credit standing negative income (cost of carry) cost from repo transactions have to be compared with normal borrowing costs eventual sales transactions might lead to irreversible costs Liquidity Risk Corp. Dr. Robert Fiedler Transfer Pricing p 20 / 28 LRC GmbH & Co. KG do not distribute -

30 Optimal Liquidity Hedging One of the most challenging aspects of the new regulation is that banks now need to continuously manage a dedicated liquidity portfolio and that the adequacy of this portfolio in hedging liquidity outflows needs to be frequently tested Two general approaches to liquidity hedging in banking industry Acquiring more assets that can generate future cash flows that can complement the potential net cash outflows (hedging with contractual cash flows, structural liquidity mismatch) Dynamic counterbalancing capacity through use of asset sales and repo agreements to generate liquidity at the exact time when net contractual cash flows cannot balance by itself (Basel III liquidity portfolio) 30 Copyright 2012, SAS Institute Inc. All rights reserved.

37 Matched Replication: Consequences for the Treasury the treasury has purchased the internal replication transaction from the origination department: its liquidity replication exposure is directly determined by the originated transaction T Ω its interest rate replication exposure is determined by the replicating floater F R every forecast bears uncertainty: expected deviations from the forecast can be predicted and its costs added : negative CF deviations are detrimental per se for illiquidity risk for interest rate risk, disutility also depends on the shape / change of the yield curve unexpected aberrations from the forecast can also be estimated: interest rate driven losses (change of CF + yield curve) require loss reserves (capital) the estimation of the magnitude of the loss drives the cost of capital unexpected liquidity deficits can only be matched by CounterBalancing Capacity; like capital, the CBC needs to be acquired a priori which drives the cost of CBC Liquidity Risk Corp. Dr. Robert Fiedler Transfer Pricing p 37 / 28 LRC GmbH & Co. KG do not distribute -

40 LCR Liquidity Coverage Ratio Basel III requires in the Liquidity Coverage Ratio (LCR) that the bank cumulates its total net cash outflows (TNCO) of the first 30 calendar days and compares this with the stock of high-quality liquid assets (HLA) the inequality to be met by the bank is expressed in the form of a ratio: stock of highly liquid assets total net cash outflows over the next 30 calendar days > 100% reflects CBC / FLE > 1 * ) CBC > FLE CBC + FLE > 0 * ) the total net cash outflows are positive in the LCR Liquidity Risk Corp. Dr. Robert Fiedler Transfer Pricing p 40 / 28 LRC GmbH & Co. KG do not distribute -

41 How Can A Bank Improve its LCR reasons for a bad LCR the bank s TNCO is too high: too many outflows from maturing liabilities - if compared with the inflows from maturing assets the bank owns not enough HLA assets (or an insufficient portion of level 1 assets) if the bank is fully match-funded: the HLA will not match the net cash outflows (TNCO) due to the 75% rule: TNCO := outflows min{inflows; 75% of outflows} possible tactical improvements with immediate effect: decreasing the denominator TNCO and/or increasing the numerator HLA requires additional funding and thus worsens the TNCO the period return of the bond (HLA eligible) needs to be risk adjusted held against the period cost of the new refinancing adjustment for the usability time (minus last month) of the bond in the LCR Liquidity Risk Corp. Dr. Robert Fiedler Transfer Pricing p 41 / 28 LRC GmbH & Co. KG do not distribute -

44 The Cost of the LCR: Internal vs. External for the bank: complicated situation, depends on the individual balance sheet for the originator: assumption that the originated transactions are match-funded economic view: inflows and outflows are fully matched in the LCR, however the net cash outflows (TNCO) will not match due to the 75% rule: TNCO := outflows min{inflows; 75% of outflows} the 25% deficit needs to be covered by HLA for the 25% HLA the difference between income and funding expense is a regulatory cost that the originator should bear the optimal tenor of HLA needs to be determined for the treasury: eventual additional cost from not-match-funded actual replication cannot be allocated to the originator but this can be substantial! works only for new business clearest solution is to reset the FTP with the residual maturities of the existing transactions (with the old rates) Liquidity Risk Corp. Dr. Robert Fiedler Transfer Pricing p 44 / 28 LRC GmbH & Co. KG do not distribute -

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